Demand for International Reserves in Islamic Countries and Determining the Optimal Composition

In this paper, based on error correction model by using panel data, an empirical analysis of demand for international reserves for 16 Islamic countries is investigated. Besides addressing conventional issues, the model explicitly incorporates the impact of expected export revenues and the impact of the exchange rate system on reserve demand. The results reveal that, short run money market disequilibrium has not any significant effect on demand for international reserves in Islamic countries. In addition, in these countries expected export revenues have positive long run effect while exchange rate flexibility has negative effect on demand for reserve Furthermore, by using the mean-variance approach this paper presents a model for selecting an optimal reserves portfolio for the Islamic countries. The model focuses on the relationship between the composition of reserves and the impact of return and risk of holding each foreign currency. Results reveal that the currency composition of reserves have been influenced by risk and return associated with holding reserves assets denominated in different currencies such that, the share of each currency in composition of foreign reserves have a negative relationship with the risk of each currency in reserves asset.